Thinking Differently: The Most Important Contrarian Behavior

Posted on Posted in Case Studies, General Thoughts, How to Improve Results, Investment Philosophy, Superinvestors, Think Differently, Warren Buffett

“I skate to where the puck is going to be, not where it has been.”  – Wayne Gretzky

One of the most important skills that you can develop as an investor is the ability to think differently. This is a broad topic with many interpretations. I often talk about thinking differently here at BHI. When it comes to general philosophy or “investment theory” (as opposed to thinking about individual stock investments), I spend more time thinking about this topic than any other. In short, I’m referring to the ability to think in a contrarian manner.

Contrarian Thinking over Contrarian Acting

But, I’m not talking about being a contrarian in the usual sense… i.e. buying stocks at new lows, buying what others hate, etc… This type of contrarian behavior typically revolves around current price and/or sentiment. When applied as part of more important inputs (namely valuation, quality, etc…), there is nothing wrong with this contrarian behavior. I often look at stocks that contrarians are interested in.

But simply buying stocks that have dropped a lot or buying stocks that others don’t like are not prudent ways to invest.

As Ben Graham says:

“You are neither right nor wrong because the crowd disagrees with you. You are right because your data and reasoning are right.”

So contrarian action is often a common denominator in successful long term investment results. But what I’m talking about is a bigger, broader definition of contrarianism. I’m referring to the ability to think differently (not just act differently).

Do You Need to Know Something the Market Doesn’t?

Geoff Gannon wrote a fantastic post recently called “Do You Need to Know Something the Market Doesn’t?“. I thought he really hit the nail on the head. Geoff is a unique and independent thinker, and I recommend reading that post in its entirety. In it, he basically states that he doesn’t necessarily feel he has much of an informational advantage over the market (i.e. the majority of other market participants).

For example, he uses the same data the analysts use when doing their valuation work. All the historical data is already known. Everyone knows what the prior year’s earnings, sales, margins, etc have been… Next year’s numbers are unknown, but many, many smart people make very good estimates on where those numbers will end up.

Geoff goes on to say that in addition to not really feeling he has an informational advantage regarding current or next year’s numbers, he also doesn’t feel he adds much value when it comes to explaining why a stock is cheap, when to sell, how to position size, and other very important strategic and tactical facets of investing.

It’s Not the Info That Matters, It’s the Way You Think About It

So if there is no informational advantage over the market, and there isn’t much value to be added in portfolio management or other strategic aspects of investing, how does one go about trying to achieve superior returns?

The answer according to Geoff (and I agree with him) is his ability to think in a completely different way than most market participants think. He talks about looking out to try and determine what will happen in “year 4”. Most market participants focus on the next year. Some might focus on 2-3 years out. Hardly anyone looks out to year 4.

Joel Greenblatt often talked about this as one of the main reasons (in addition to superior portfolio management tactics) he was able to achieve 40% returns for 20 years.

So simply extending the time frame is one way to gain a major advantage. Instead of focusing on how the current news will affect the company in the next year or two, try to visualize what will happen in year four. Buffett even took it beyond that saying that before he bought any stock, he closed his eyes and tried to visualize what the company would look like in ten years.

No one does that. Or I should say… no average investor (professionals included) does that. A very, very select few do. And often times this is a common denominator among the small group who have crushed the market averages over the long term.

Look where no one else is looking. “Go where the puck is going to be”, not where it is now (which is where everyone is looking).

What Metrics Matter? Think Differently…

So changing the time frame is one way to build an edge. Another is to begin to place importance on things that no one else cares about. For instance, Coke is a case study that you can learn many things from. Buffett and Munger both shocked the value investing world when they paid 15 times earnings for an established, large cap, well-known brand name with virtually no tangible asset protection. This Coke investment in the late 80’s exemplified the art of thinking differently.

I’m not suggesting that you should arbitrarily begin paying high multiples for good businesses. I’m just suggesting that you can learn something by studying the thought process that Buffett and Munger used to make their Coke investment.

A while back I wrote a post on Pabrai’s thoughts on why Buffett bought Coke. He and Munger didn’t think about current earnings, or next year’s earnings. They thought about things like:

  • Brand replacement value (estimated at five times the then market value)
  • Volume of syrup shipped in the year 2000, 2025, 2050 (remember, they did this analysis in the late 80’s)
  • Daily per capita consumption of bottled beverages
  • Price per eight ounce serving

Not exactly the typical metrics. No multiples, no margins, no forward year estimates…

As Mohnish Pabrai said in his book:

The typical hammer-wielding Wall Street analyst is fixated on the next few quarters, not the next half century when trying to figure out any given company. No Wall Street analyst’s mental model of Coke in 1988 was comprised of the latticework that Munger and Buffett fixated upon.

One more thing about Coke… Please read Charlie Munger’s thesis on How to Turn $2 million into $2 trillion (who one outstanding fund manager called the best investment writeup he’s ever seen).

Again, you’ll find lots of unique, inverted thinking.

Munger and Buffett thought differently. This is how they were able to make 10 times their money on Coke. This is how Buffett made 50% per year, and guaranteed he could do it again if he could only go back to managing a smaller sum.

It All Comes Down to Thinking Like a Business Owner

Last thing… I love simplicity (as I’ve mentioned many times). The simple conclusion here — the moral of the story so to speak — is that Buffett and Munger thought about stocks the same way businessmen think about the businesses they buy/own. I know, this is ubiquitous language… “think about stocks like fractions of businesses”. Everyone says it. But, hardly anyone actually invests this way.

I guarantee the vast majority of investors who were fortunate enough to buy Coke in the 80’s were not thinking the way Buffett and Munger were. Buffett was thinking years, even decades ahead. Like a business owner.

It paid off… and it’s a way to gain an advantage over the vast majority of market participants who think about things like relative value, what another investor will pay in a year or two, or what next year’s earnings are.

To sum it up… two things that can establish a true contrarian advantage are:

  • Extend the time frame (via Geoff Gannon’s outstanding post)
  • Place importance on things that others aren’t thinking about 

These are just two things… there are countless of other ways to think about investments.

The main thing is to Think Differently. Think like a business owner would. Simple, but uncommon.

Have a great weekend…

9 thoughts on “Thinking Differently: The Most Important Contrarian Behavior

  1. This is a wonderful article. Thanks for sharing. There is a market segmentation in the way different investors look at it. Most investors or fund managers are concerned about beating the index for the year and hence fixated on the NTM earnings (or relative earnings) multiples, rather than the 3-5 year or even longer term outlook. This imbalance provides opportunity to those who can identify it.

    In the long run, thinking like a business owner is truly the way to be an investor. Metrics such as per capita consumption, price per bottle, etc. and similar such metrics for other industries, provide you with incredible insight, not apparent from textbook multiples.

    I read every word that you write. Keep up the good work. Thanks.

  2. Hi,

    In some ways I agree, but yet disagree with the premise of this post. I believe Buffett claimed he could make 50% because he would be investing in small stocks where you can actually gain an informational advantage. There was a video where he spoke to this at a lecture in India, he said if he ran less than $10m he would be investing in small Graham net-net, low P/B companies.

    I know first hand that informational advantages exist in small companies. Take Avalon Correctional for instance. They issued a press release saying they lost a lawsuit and would be buying out minority shareholders at $4.05 a share. Yet shares traded at $3.00 for weeks after the release. If one inquired further you’d find that shareholders also received a preferred stock worth $1.70 a share that pays a 7% dividend. There was a true informational advantage with this, the news appeared on some local news websites, you had to be looking for it. Many market participants didn’t and sold very cheap, this was money laying in the open.

    I talked with someone recently who does a lot of deep value investing as well as small bank investing. He said his goal is to be one of the three or four investors with superior information about a company that he invests in. With many small banks that’s simple, there is literally no investor interest and just researching the company and talking to the CFO for 30m puts him in that position. Anyone can do this, yet most don’t.

    There are holdings where I’m sure I have more information than maybe four or five other investors as well.

    But here’s the key, you don’t need an informational advantage always, and you don’t even need to think differently. You just need to be able to identify egregious mis-pricing, determine it’s incorrect and have the courage of your own convictions to purchase. I’ve heard this called the killer instinct in investing. The ability to look at a company and see what’s wrong with the market price and to act right away. Not needing to build a model, or project earnings to year four or anything crazy.

    Nate

    1. Nate, great comment. And great points. I did see the Buffett video, and one thing I’d clarify: He said he’d look at “everything”. Not necessarily just small caps, but small and large caps-wherever he could find value. But, I certainly agree that more opportunities abound in the smaller stocks, specifically the types that you like.

      My thoughts are basically that thinking differently is the first step to creating a long term record. This doesn’t mean you have to be a genius, or have to have Buffett’s brilliance, or anything like that. And I’m not necessarily advocating buying large cap growth stocks like Coke. I just wanted to use that as an example that Buffett and Munger considered things that others weren’t looking at.

      I love Walter Schloss, and I talk a lot about his methods. He bought simple, cheap stocks for five decades. And he owned 50 or more stocks at a time, and did very basic analysis based on net tangible asset values. All he wanted to do was buy a stock at a discount to what a private buyer would pay…. so this wasn’t high level thinking, but I would argue that it was thinking differently. (Very few did what he did, and certainly not for as long as he did).

      Schloss thought (and acted) differently than most other investors. Just like Buffett (although those two used completely different value investing techniques).

      So I don’t think that you need “high level” thinking per se, just “different thinking”. I actually love simplistic thinking. Things that are easy to understand. Looking at Coke again, and reading about Buffett’s thought process, it actually is quite simple. It has nothing to do with margins, earnings projections, or anything like that. Just that the product has a valuable brand, syrup consumption had increased for over a hundred years without a single down year, etc… very simple logic, but certainly a different thought process than most others.

      Your example with the arbitrage situation and the small bank stocks is excellent. And although those situations represented obvious value, and didn’t require much thought, I would argue that the process that led you to those ideas is an example of thinking differently. Most people don’t look there, thus leaving lots of inefficiently priced opportunities.

      So in the end, I’m not trying to suggest that you need to develop certain insights, just that you need to go where others aren’t looking. This could be extending time frame (as in the example I used), or in simply looking at small/micro cap stocks where no one else will look.

      Whether they are earnings based or asset based investments, I think simple, yet contrarian thinking can be helpful.

      Thanks for the thoughtful comment Nate. It’s always beneficial to bounce around these ideas. And great examples…

  3. I agree with Nate. Warren Buffett can make 50% per year only by investing in small, obscure kind of companies where big investors cannot enter and so not many have information about the business.That is what he meant when he said that. And in those situations it does not make sense to think 5 years or 10 years or forever. You exploit value-price arbitrage opportunity in deep value stocks…sooner you realize the value the better. Something that he did in his earlier partnership.

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